by

Paul F. Roye

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
June 24, 2002

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

I. Introduction

Thank you and good afternoon. It is a pleasure to be here with you today. I'd like to take this opportunity to discuss some regulatory developments at the Commission in the investment management area over the past year, particularly those affecting variable insurance products. As always, my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the staff.

Baseball legend Yogi Berra is credited with many famous quotes, like the immortal words: "we're lost but we're making good time." Or the sage advice Yogi once gave when he said: "you should always go to other people's funerals, otherwise they won't come to yours." Perhaps Yogi's most famous quote is "when you come to a fork in the road, take it." I thought of this quote in connection with this talk, because in a certain sense we frequently find ourselves at forks in the road at the SEC. We always have the ability to continue on the current course by pursuing "business as usual." But I think that our mandate to protect investors is best served when we are flexible in our administration of the securities laws  when we adapt our approach to changes in the securities markets. Mindful of this, we seek to remain on watch for forks in the road-opportunities to diverge from our past course and to pursue better, more effective ways to administer the securities laws. This has been Chairman Pitt's direction to us. As many of you know, Chairman Pitt has made increased efficiency and modernization of securities regulations a priority at the Commission. Consequently, in the Division of Investment Management we have been reviewing our rules and interpretations to determine which of them are ripe for overhaul to better protect investors and respond to industry developments.

I think this is particularly important in the area of variable products because of the dramatic changes that have characterized this industry of late. Just last week we saw a new study by Info-One that points to interesting trends in variable annuity design and distribution. One such trend that has captured a great deal of our attention recently is the unbundling of benefits. With unbundled features, a variable annuity can be customized using benefit choices to focus on the benefits best suited to an investor's needs. The study noted that currently over 140 contracts offer a choice of benefits, whereas a year ago, just over 80 contracts offered a choice of benefits. This raises obvious disclosure issues, but it raises other potential issues as well. Citing a recent survey, the study noted that almost 70% of the dealers surveyed believed these contracts to be too complex. The complexity of the products, combined with what dealers felt was the lack of support and education about these features, caused many distributors to cite the potential for suitability problems. We will certainly be keeping our eye on this issue, but I mention it here because I think it indicates how changes and innovations in this industry present a challenge to the Commission-to ensure that our regulations and our disclosure standards are well suited to the securities being regulated.

It is in this context that we are also reviewing our regulations to identify those that can be streamlined or revised to ease regulatory burdens, without compromising the protection of investors. Recent actions by the Commission, as well as the Staff, reflect Chairman Pitt's commitment to efficient and effective securities regulation. Let me just review with you a few highlights in this regard.

II. Forms N-6, N-1A and N-4

Those of you who were here last year may remember me saying that if I showed up here again this year without Form N-6 duly adopted by the Commission, that I, Susan Nash and Bill Kotapish would stand on our heads before this conference. Well, I don't know about you, but I am glad to say that we won't be putting on that show today  N-6 has been adopted. I consider this form a major step towards our goal of improvement and simplification of disclosure for investment company securities. Previously, variable life registration statements had to be adapted to forms designed for traditional unit investment trusts. As a consequence, disclosure for variable life products was often lengthy and complex, but not particularly useful, because the forms did not elicit the kind of disclosure that is important to investors in variable life products. The new Form N-6 focuses disclosure on information that is important to variable life investors, including information about premiums, death benefits, cash values, surrenders, withdrawals, and loans. I won't give you a blow-by-blow account of all of Form N-6's new features-Paul Cellupica from our Office of Disclosure Rulemaking will be on a panel tomorrow that will tackle that job. Instead, I'd like to just highlight two key features of the form-the fee table and the illustrations.

Under Form N-6, for the first time, variable life insurance prospectuses will be required to include a fee table similar to those long required for both mutual funds and variable annuities. Although charges for VLI products are more complex than charges for these other types of investments, it is important that investors receive clear, understandable disclosure allowing them to compare fees and charges among different policies. The Commission determined that the standardized fee table was the best means to achieve this objective.

In the table, we are requiring that all charges be disclosed, including rider charges, even though any given rider charge may only apply to a limited number of policyholders. Some commenters argued that if rider charges were included, policyholders would be overwhelmed by information that did not apply to them. In the adopting release for Form N-6 the Commission noted, however, that in recent years, insurers are increasingly offering "unbundled" variable insurance products, in which a basic policy is offered and investors can pick and choose from a myriad of different riders to create a product that meets their individual needs. Because it would be impossible to identify those riders that would be of interest to the "typical" investor, the Commission determined that a requirement that all charges be shown in the fee table would serve the needs of the greatest number of investors.

The new form also requires that the cost of insurance be presented as a range from the minimum to the maximum charge that may be imposed under a policy. In addition, issuers must include the cost of insurance charge that would be paid by a purchaser who is representative of actual or expected purchasers of the policy. We believe that this type of presentation will serve as a flag to prospective investors that the cost of insurance charge can be a significant charge that bears further investigation.

As for the underlying fund expenses, the form calls for disclosure of the range of expenses for all of the underlying funds, rather than a complete presentation of the fees and charges for each fund, although an issuer is allowed to provide fee information for each fund in addition to the range of fees. Because the new Form N-6 only requires disclosure of the range of underlying fund expenses, we have revised Form N-1A to require a fee table for mutual funds that offer their shares as investment options for variable insurance products. Previously, a fee table was not required in the prospectuses for these types of mutual funds.

In conjunction with the adoption of Form N-6, the Commission proposed revisions to Form N-4 to conform the treatment of underlying fund expenses in a variable annuity prospectus to the format used in the N-6. As a result, for example, a variable annuity prospectus would show the range of expenses for all the underlying funds offered under the annuity contract. As with variable life insurance policies, the number of investment options available through a typical variable annuity has expanded considerably in recent years, and with that growth, prospectuses have also grown longer. We believe use of a range will simplify fee tables for variable annuity contracts.

Another significant aspect of the new N-6 concerns the use of illustrations. The form permits, but does not require, registrants to include hypothetical illustrations of a variable life insurance policy in either the prospectus or the SAI. If a registrant decides to include illustrations, they must comply with the requirements in the form. These requirements include a narrative preceding the illustrations that discusses the assumptions and limitations of the illustrations. The illustrations themselves must include one example that assumes a 0% gross rate of return, one 6%, and one using another rate not greater than 12%. Here I want to point out that, even though the form permits a 12% assumed return, all assumptions must be reasonable in light of an issuer's circumstances, and a 12% illustration may not be appropriate for some issuers, depending on historical performance and expected allocations.

We also wrestled with the contentious issue of personalized illustrations. While the form does not address the format of personalized illustrations, it does require that registrants who make personalized illustrations available must disclose that fact and provide a toll-free number for requesting them. We have not at this point prescribed standards for personalized illustrations. We have cautioned in the past, and I caution you here, to tread carefully in constructing a personalized illustration. For instance, an illustration that reflects only one underlying fund's fees and charges could be misleading, especially if that fund's fees and charges are low relative to the other funds offered, unless the investor for whom the illustration is made actually invests or expects to invest in the single underlying fund.

As I mentioned, there will be a panel later that will take you through the nuts and bolts of the form. Let me just add that the staff stands ready to work with VLI registrants in adapting to the new form and making the transition as smooth as possible. We urge you to take this opportunity to craft the best disclosure possible, disclosure that as clearly as possible explains your product and the terms of your offering. We think the new form will prove to be a helpful vehicle for doing so, and we look forward to working with you over the next year in accomplishing this goal.

III. Substitutions

Another area of great activity for the staff over the past year has been substitution applications. Since I spoke at this conference last year, we have processed 17 substitution applications, several of these involving multiple substitutions. I think there are several factors driving this high number of substitutions, including consolidation of the fund industry, and the desire of variable product issuers to streamline their investment options. In some cases, the substitutions are part of an initiative to realign the investment options by bringing assets into proprietary funds managed by an affiliate of the insurance company. While we recognize that substitutions may be wholly appropriate and in some cases even necessary, nevertheless, some scenarios obviously raise significant regulatory concerns. As we are required by Section 26(c) of the Investment Company Act to make a finding that a substitution is in the contract owner's best interests, we look closely at each proposed substitution before approving an application. In some cases, the approval is subject to strict conditions grounded in concerns for the protection of contract owners.

Having said that, I would also point out that we have, in some circumstances, eased the regulatory burden of substitution applications. Specifically, in the past year we have granted two no-action letters to companies facing the liquidation of an unaffiliated fund, who sought to invest the liquidation proceeds in a money market fund on behalf of those contract owners who had not given alternative allocation instructions. In both cases, the liquidation had been approved by the underlying fund's board because of its small asset size, its perceived lack of growth potential, and concern for increasing expenses. The staff considered several factors in making these decisions, including the fact that there was no affiliation between the insurance company and the liquidating fund involved in the transaction, which suggested that the transaction was not undertaken to enrich the insurance company or its affiliates to the detriment of contract owners. We also considered the fact that notice had been sent to contract owners along with the opportunity for them to select alternative investments, the fact that there was a variety of investment options under the contract with free transfer privileges, and the lower expenses of the money market fund. We also believed that the default allocation to a money market fund was appropriate in these cases because money market funds generally are regarded as suitable short-term cash management vehicles. Taken together, the staff determined that the facts and circumstances surrounding the allocations provided enough protection against the abuses that Section 26(c) targeted and, as a result, granted the relief.

In another no-action letter, an insurance company wanted to replace a more expensive class of shares with a cheaper class of the same fund. Due to a proposed reorganization of some underlying funds, the insurance company's separate account would hold two classes of the same fund. The class B shares had 12b-1 fees and minimally higher "other" expenses than did the class A shares, which had no 12b-1 fees. The insurance company wished to give certain contract owners with assets currently allocated to the more expensive class B shares the benefit of lower fees. In my view, switching classes within the same fund is not necessarily outside the scope of Section 26(c). Nevertheless, we granted no-action assurance because the effect of the proposed transaction was to give contract owners an investment in the same fund managed by the same investment adviser but at lower cost.

I mention these no-action letters because I think they are a good reflection of the staff's flexibility in this area and of our openness to considering the shareholder protection concerns raised by each proposed transaction. It is our understanding that several insurers, under similar circumstances, have forgone the filing of substitution applications as a result of these letters.

For those that do file applications, we have also sought to be flexible in applying our standards for exemptive relief, while at the same time seeking to fashion workable standards that can be applied consistently to like applications. This has resulted in several refinements to our analytical model in response to particular facts presented in applications over the past year. So, for example, you will notice refinements to the scope of undertakings in applications regarding expense caps. You will also notice recent changes in the representations some applicants provide regarding revenue sharing arrangements between the applicants and the management of the unaffiliated funds involved in substitutions.

As we move forward, I am confident we will continue to receive substitution applications that require new exceptions or refinements to our exemptive standards. Overall, our focus will continue to be whether a substitution involves the abuses against which Section 26(c) was designed to protect.

IV. Market Timing

Last year I spoke to you briefly about the topic of arbitrageurs and market-timers and the problems that they cause funds and their long term shareholders. As I said then, we are sympathetic to funds that try to discourage market timers from using their funds as short-term trading vehicles. Of course, the tax deferred status of variable products makes them attractive to timers, so the problem is particularly pressing for many funds underlying variable products. At that time we were beginning to see the imposition of redemption fees for contract owners who transfer amounts among sub-accounts on a short-term basis according to market timing strategies. This development raised interesting logistical issues because of the relationship between the underlying funds and the separate accounts that are the record owner of the fund shares.

This past year we have seen further developments in this area. Of particular note has been an initiative by certain funds that sell to multiple insurers to establish a redemption fee class of shares to be sold to certain separate accounts, while a different class that doesn't impose the fee is sold to others. There are several reasons why this might make sense. For example, some underlying funds are offered through separate accounts of several insurance companies that may have different levels of market timing activity by their contract owners, or different technical capabilities, so that some, but not all, of the insurance companies are willing and able to collect a redemption fee imposed by the fund. A redemption fee class may be offered exclusively to separate accounts of insurance companies that have agreed, and have the systems in place, to enable the fund to charge a redemption fee to contract owners who transfer in and out of the fund on a short-term basis. The fund could still be offered to other insurance companies whose contract owners do not engage in significant timing activity, or for whom the fee is not practicable, through another class of fund shares that does not charge a redemption fee. This is a recent development, so far involving only a few funds, but I would not be surprised if we continue to see registration statements or post-effective amendments for funds offering classes that differ specifically with regard to redemption fees in this context.

In November of last year, a court upheld the legality of another method by which variable annuities can discourage market timing. A district court ruled that companies could require market timers to conduct exchanges by mail. In this case, the contract holder had made several round-trip trades into an equity account during the first five months the account was open. Round-trip trades are trades into and out of funds within relatively short time periods. The insurance company sent several letters indicating that future trades would have to occur by mail, but for a period of time, the account holder was able to convince the company to let him keep trading. Eventually, the company cut off his telephone, fax and Internet exchange privileges, and the account holder sued. Citing "a very clear and undisputed paper trail which include[d] the prospectus, the deferred annuity contract and correspondence between the parties," the district court stated that the insurance company was within its rights to curtail his exchange activity. The prospectus and annuity contract stated that round-trip trading was prohibited. The court's decision allows the insurance company to impose slower exchange methods  like the U.S. mail  on certain contract holders without imposing the same requirements on all customers.

The staff is also engaged in discussions with industry representatives regarding other proposed responses to the timing problem. For example, some have proposed delaying requested exchange transactions between funds for some period of time, or delaying the purchase portion of the exchange for some period of time after the redemption portion has been completed. As many of you know, the staff has traditionally viewed exchange requests as simultaneous redemption and purchase orders, requiring prices on both transactions to be based on the net asset value next determined after receipt of the order. So we are being cautious in looking at these types of proposals, while we remain mindful of the very significant problem of market timing faced by the fund industry. We look forward to a continuing dialogue with the fund industry with a view towards workable solutions to the market timing problem.

V. Advertising

Let me turn now to a current rule proposal that I think is a significant development for the industry. The Commission has proposed to amend rule 482 to increase funds' flexibility in advertising by eliminating the requirement that fund advertisements contains only information the substance of which is included in the statutory prospectus. This requirement has resulted in laundry lists and boilerplate statements cluttering fund prospectuses and statements of additional information. This has prevented funds from including timely information in their advertisements, such as information about current economic conditions that normally would not be included in a fund's prospectus. Accordingly, we hope that the proposed change will make fund advertisements more informative and streamline fund prospectuses.

The fund advertising proposals also would require that fund advertisements that contain performance provide additional information to give context to investors when reviewing performance information. The Commission has proposed that all fund advertisements that contain performance information include the following:

Disclosure that past performance does not guarantee future results and that current performance may be lower or higher than the performance quoted;

Disclosure that would direct investors' attention to a fund's charges and expenses; and

Disclosure of important information, such as the dates during which quoted performance occurred.

The proposed amendments would also require funds that advertise performance to make available, by a toll-free or collect telephone number, returns that are current to the last day of the previous calendar month. Fund advertisements would be required to identify the telephone number and, if available, a Web site where an investor could obtain this information. Under existing rules, funds that advertise performance information typically include returns for 1-, 5-, and 10-year periods that are current to the last day of the most recent calendar quarter. Finally, these amendments would reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws.

Hand in hand with this amendment, which allows more information to be included in fund advertisements, the Commission has proposed amendments intended to reinforce antifraud protections and encourage the provision of information to investors that is more balanced and informative, particularly in the area of investment performance. The Commission's concerns that mutual fund advertising could mislead investors or create unrealistic expectations were heightened when many funds engaged in advertising campaigns that highlighted their impressive performance during the period of extraordinary market returns in 1999-2000. In response, the Commission is proposing to amend rule 156 under the Securities Act. Rule 156 provides guidance about the factors to be weighed in determining whether a statement involving a material fact in investment company sales materials is, or might be, misleading. The Commission has proposed to modify the language of rule 156 to state that portrayals of past income, gain, or growth of assets may be misleading where the portrayals omit statements necessary or appropriate to make these portrayals of past performance not misleading. For example, there may have been unusual circumstances that substantially contributed to a Fund's performance over a reporting period.

We also took the opportunity of this rule proposal to solicit comments on an issue regarding prospectus delivery requirements for variable insurance products. Rule 482 generally prohibits a fund advertisement from containing or being accompanied by an application to purchase fund shares. There is an exception in the rule that allows a variable product prospectus-which generally constitutes a rule 482 advertisement for underlying funds described in the prospectus-to include an application, even though the prospectuses for the underlying funds do not accompany the contract prospectus. Some have suggested that, in light of this exception, it should be permissible for a contract prospectus and application to be accompanied by other types of rule 482 advertisements for the underlying funds that are not part of the prospectus itself.

We think it would be useful to clarify the ambiguities in the scope of the insurance exception from the application prohibitions of rule 482 so that variable product issuers may operate with greater certainty. For this reason, we solicited comments on several specific questions related to this issue. We look forward to any comments you may have.

VI. Affiliated Transaction Relief

The Commission has also proposed amendments to the rules governing affiliated transactions with registered investment companies. The Investment Company Act contains a number of provisions designed to prevent affiliated persons who may be in a position to take advantage of their relationship with a fund, from entering into transactions or certain other types of arrangements with the fund, unless the Commission enters an order approving the transactions. The modern fund complex typically includes numerous affiliated persons and entities, including subadvisers, all of whom are constrained in their dealings with the funds under these provisions, even though many of the prohibited transactions involve little potential for overreaching or abuse. The Division of Investment Management issues many exemptive orders approving affiliated transactions each year, which is costly to both the industry and the Commission. For this reason, the Commission has proposed a rule and amendments to existing rules that would codify the relief granted in many of the orders the Division issues each year. They would eliminate the need for funds to obtain individual exemptive orders in certain circumstances that we believe are not likely to raise the concerns that the Act was intended to address.

The first of these proposals involves transactions between a fund and its portfolio affiliates. Currently, SEC rules permit a fund to enter into transactions with a company that is affiliated with the fund as a result of the fund's ownership interest in the company. This type of affiliated person is unlikely to be in a position to take advantage of its relationship with the fund. The Commission has proposed that the rules be expanded to permit a fund to enter into transactions and arrangements with a company that is similarly affiliated with one or more other funds in the fund complex. This is largely a technical change necessitated because the current exemptive rule pre-dated the widespread organization of large fund complexes.

The second area is in transactions with subadviser affiliates. Fund advisers are, of course, also "affiliated persons" of a fund. As a result, an adviser to a fund cannot engage in principal transactions with the fund or any other fund in the fund complex. The SEC has, however, issued a number of orders permitting subadvisers to enter into transactions and arrangements with funds in the complex other than the fund it manages. These transactions involve little potential for self-dealing because the subadviser participating in the transaction is not making investment decisions on behalf of the fund involved in the transaction. Accordingly, the Commission has proposed new Rule 17a-10 to permit these types of transactions without individual exemptions.

Third, the Commission has proposed amendments to Rule 17a-8 that would liberalize the exemption that rule provides for mergers of affiliated funds, and therefore would reduce the number of exemptive applications filed with the staff. In a nutshell, the proposed amendments would significantly expand the scope of rule 17a-8 to allow mergers of funds that are affiliated with one another for any reason, not just the limited types of affiliations permitted under the current rule. The amended rule would also facilitate mergers of bank common trust funds and collective trust funds into registered investment companies.

The Commission's recent fund governance amendments, and the industry's recent efforts to strengthen the independence and effectiveness of independent directors, have laid the groundwork for this type of proposal-and very likely for similar future proposals. Greater comfort can be taken in expanding exemptive rules knowing that actions taken under those rules are monitored by a strong legion of independent-minded directors.

VII. GAO Report; Special Study

While the Commission's efforts to update and modernize its rules should undoubtedly be helpful to those of you who counsel clients in this area, I know that there are other areas in which you would like to see improvement. One of these areas is the amount of time it takes to process no-action letter and exemptive application requests. A recent GAO Report stated that resource constraints have contributed to delays in the turnaround time for many Commission regulatory activities. The GAO Report also noted that, over the last decade, increases in Commission workload have far outpaced increases in Commission staffing, causing an imbalance in workload and staffing.

Chairman Pitt recently announced a Special Study to examine the Commission's operations, efficiency, productivity and resources. The Special Study group, which is comprised of mid- and senior-level staff from the various divisions and offices in the Commission assisted by an outside consultant, is focusing on improving procedures, proposing more effective use of technology and examining workload and staffing issues and the role they may play in delaying the issuance of no-action letters, exemptive orders and rulemaking actions. The hope is that we can identify strategies and solutions to make us more efficient.

VIII. Proposals for Exemptive Rules

As we explore ways to speed up the exemptive applications process, we recognize that one method we can use to eliminate some of the backlog is to codify certain frequently-requested forms of relief. The rule 17a-8 proposal is an example of this type of rulemaking. The staff is actively working on other recommendations to the Commission to propose exemptive rules and rule amendments in other areas where we receive frequent requests for relief. I will just mention two of these identified in submissions to us that I believe would be of particular interest to NAVA and its members.

The first possible proposed rulemaking concerns substitutions. It has been suggested that the Commission should propose a rule to permit certain types of substitutions without the need for a Commission order under Section 26(c) of the Investment Company Act. As I mentioned earlier, given the number of applications we see in the area, it is ripe for rulemaking.

The second proposal is for an exemptive rule to permit mixed and shared funding. Currently, exemptive relief is required if an underlying fund proposes to sell its shares to VLI separate accounts in addition to VA separate accounts and/or tax-qualified plans. Exemptive relief is also needed if a fund sells to VLI separate accounts of two or more unaffiliated participating life companies that are not affiliated with one another. The Commission has granted over 140 exemptive orders permitting mixed and shared funding. These orders impose a set of conditions for exemptive relief,
including monitoring by the fund and by the participating insurers for the existence of any material irreconcilable conflict among the interests of various variable contract owners investing in the fund, and a requirement for action in the event a conflict is identified.

Proponents for a rule have questioned whether our experience with mixed and shared funding warrants the concern for conflicts among different types of fund shareholders that underlies these conditions. They also question whether these conflicts are more likely to arise with funds supporting insurance products than with other types of open-end mutual funds. We are taking industry recommendations on this matter under advisement, and encourage you to add your thoughts on this matter.

We are looking seriously at these proposals. I cannot guarantee that, at the end of our inquiry, the Division would indeed recommend one or both of these rule proposals to the Commission, much less what the Commission would do in response to a recommendation. But I mention these proposals because our consideration of them underscores our commitment to examining possible areas of change and improvement in the regulatory framework.

VII . Conclusion

I hope that you have noticed a common theme running throughout the actions and initiatives I have been discussing. In each case we have been working towards more efficient and effective regulation of variable products and underlying funds. Where appropriate, we are easing regulatory burdens on issuers consistent with the protection of investors. Of course, more can and will be done. We look forward to hearing from NAVA and from you individually as to what you think the priorities ought to be. We welcome your ideas and suggestions.